Home / Opinion / Advice industry needs more critical thinking about alternative assets

The benefits of alternative investments are clear, but rapid growth in the product set has made the optimal use of alternatives in portfolios unclear. As markets reach all-time highs, it may be time to re-think how we treat the asset class.

Alternative assets are among the most popular investment products amongst investors and advisers alike. Making the case for alternatives is simple due to their non-correlative advantage, but including them within client portfolios on a broader scale is anything but.

Referring to any asset which isn’t a traditional share or bond, alternatives can include anything from hedge funds and high frequency trading, to venture capital, private equity and the flavour of the moment, private credit.

The story behind alternatives is clear, as are the apparent benefits; higher returns, better risk-adjusted outcomes and lower correlation with traditional assets which make up the bulk of portfolios. Yet the advice industry remains well behind the institutional and industry fund sectors in alternative investment, having as little as 5 per cent in ‘alternative-lite’ investments compared to as much as 20 to 30 per cent on the institutional side of the fence.

Working with asset consultancy Atchison Consultants to build managed portfolios for our clients at Wattle Partners, what stood out was the lack of depth when it comes to alternative investments available within this structure.

The benefits of managed accounts like SMAs are well appreciated, including the efficiency and salability it adds to an advice practice. Yet the ability to build a truly ‘alternative’ portfolio within a managed account structure can sometimes be constrained.

For better or worse, as gatekeepers of capital, platforms usually require investment product providers to offer a significant level of liquidity to be included in a discretionary account. Yet one of the core benefits of investing into alternative assets is their lack thereof and the consequent ‘illiquidity premium’ afforded investors.

The issue is twofold. Firstly, the requirement of liquidity all but rules out the majority of the truly high-performing, alternative asset classes like private equity or distressed credits, significantly limiting the menu of options available to clients.

Secondly, the result is that an alternatives allocation via a discretionary model is ultimately a ‘defensive’ alternative allocation, as the few alternatives available on most menus are those seeking lower volatility than traditional asset classes; ‘defensive alternatives’, as we call them.

By no means is this a suggestion that these are not high quality, well-diversified and valuable strategies for investors, but rather it is difficult to justify holding ‘defensive’ assets within the alternatives portion of a portfolio that falls within the ‘growth’ allocation. At worst, this limits the potential return of the portfolio. At best it shields investors from shock periods of volatility.

While innovation and improvement has come, by and large the majority of alternatives remain inaccessible to the masses, with a number of schools of thought emerging in terms of how an adviser can solidify their alternative allocation.

There’s an argument to be made for holding a separate line of alternative assets within portfolios, or possibly even splitting alternatives into defensive, liquid alternatives, and illiquid growth options. But this presents a critical questions: how would these sleeves then fit within a broader portfolio construction framework?

The need for more critical thinking around alternative investments is growing with most markets nearing all-time highs. For financial advisers and other custodians of capital, prudent preservation of capital may depend on it.